Sunday, June 22, 2014

The monetary economics of the roll-up

The so-called corporate "roll up" lies at the conjunction of finance and monetary economics. For those monetary economists who aren't familiar with the term, a roll-up is a company that tries to consolidate an entire industry by serially acquiring competitors, usually using its own stock as currency. Valeant Pharmaceuticals, currently in the midst of a battle to take over botox-maker Allergan for $53 billion, is one of the more well-known roll-ups in the world of finance these days, having acquired around 75 companies in the specialty pharmaceutical niche over the last six years. But there have been many others over the years who have pursued the roll-up strategy.

Plenty of analysts dislike the corporate roll-up. They criticize it for not creating value organically but merely accumulating other people's castaway businesses. Roll-up equity is generally viewed as ridiculously overvalued and destined to implode. Valeant, for instance, has been variously described as a house of cards, Kool Aid, and something from the Wizard of Oz.

I'm going to argue in this post that a roll-up is less nefarious than some people think. A roll-up does the same thing that a bank does—it is a liquidity provider. In the same way that a bank expects to be compensated for turning the illiquid into the liquid, a roll up deserves to be paid a fee for doing the same. Like banks, roll-ups are monetary phenomena.

Let's build a roll-up from scratch. Our roll-up begins its life as a regular business, say a fishing store. Like all other fishing stores in the area, the store yields its owner, Bob, about $10 a year. Fishing stores generally distribute all their earnings to their owners so that nothing is retained in the business. A store can generally be bought and sold for around 5 times earnings, or $50 ($10/year x 5), although due to their illiquidity it may take a lot of time and effort to match buyers of fishing stores with sellers.

Bob's first task is to make the ownership position in his store more liquid. He decides to divide his $50 stake into 100 shares, each worth 50 cents, thus rendering it easier for people to purchase bite-sized positions in his business rather than being required to gulp the thing whole. He hires a store manager to take care of day-to-day business, buys himself an Armani suit, and begins to canvas the land marketing his shares. He may even take the time and effort to list on a public stock exchange.

Eventually, shares in Bob's store will have attracted a large crowd of buyers and sellers. Whereas all the other fishing stores in the area remain relative illiquid, an ownership stake in Bob's store has become more moneylike. A liquidity premium attaches to the value of the shares. Each of the 100 shares is now priced at 75 cents which puts a $75 valuation on Bob's business ($0.75 x 100 shares), twenty-five bucks higher than the $50 price tag that was originally placed on Bob's store and is currently being placed on competing fishing stores. Since Bob's store continues to earn the same $10 a year that other stores make, the twenty-five buck premium is entirely related to the superior ease that owners of Bob's business enjoy in transacting with their shares. Both Bob's Armani and his hard work have paid off.

Here's another way of looking at the scenario. Whereas all fishing stores trade at around 5 times earnings, Bob's shares trade at 7.5 times earnings due to their superior liquidity.

Bob now embarks on the next stage of executing his roll-up strategy—issuing new stock to buy up his competition. He begins by printing up 66.6667 new shares and offers to buy Joe's fishing store down the street for a total value of $50 (66.6667 shares x $0.75/share) . This is where the magic of the roll up strategy begins. If Joe accepts, Bob will now have two stores earning a combined $20, each share earning $0.12 ($20 / 166.667 shares). Notice that this is an improvement over the $0.10 per share being earned prior to the deal with Joe ($10/100 shares). Since the market continues to value Bob's shares at 7.5x earnings due to their excellent liquidity, each share will now trade for 90 cents (7.5 x $0.12 earnings per share), higher than their pre-purchase price of 75 cents (7.5 x $0.10). Thus Bob's shareholders enjoy an immediate 15 cent pop in the share price once Joe's store is bought! Not bad for a day's work. This is what is called an accretive acquisition.

Intuitively what is happening here is that Joe's illiquid ownership rights are being brought under Bob's umbrella. They are immediately rendered just as liquid as Bob's ownership position, and since liquidity is a service that the market is willing to pay a premium for, Joe's ownership rights will now be worth more than before.

It makes sense for Bob and his shareholders to push for the deal with Joe since they enjoy an immediate gain. But what about Joe? Why would he agree to the deal? Consider that before the agreement was struck, Joe was comfortably earning $10 a year selling rods and hooks. After the transaction is over, he'll own 66.6667 shares of Bob's business, each share yielding $0.12 in earnings, for a total of just $8 a year vs $10 before. So if he signs on the dotted line, he'll be earning $2 less each year. A terrible deal for Joe, right?

Not necessarily. The reason Joe may very well take the deal despite earning less finds an answer in Carl Menger. For finance types, Menger was a 19th century economist who pretty much nailed down the idea of liquidity, or what he preferred to call marketability, the fact that "different goods cannot be exchanged for each other with equal facility." Menger gives the example of a black smith who, when going to market with his newly made armour, has difficulties locating someone willing to trade food and fuel. Rather than seeking to directly trade, it is in the smith's interest to take an indirect route by accumulating some good that though useless to him, has greater marketability than the armour he has produced. In this way, the smith gives up his less saleable commodity for others of greater marketability since "possession of these more saleable goods clearly multiplies his chances of finding persons on the market who will offer to sell him the goods that he needs."

Returning to our story, let's say that Joe is tired of working and wants to retire so that he can travel around the world. Travel will require cash, but Joe's business isn't very easy to sell. In a strategy that Menger would approve of, Joe may choose to give up his shares in exchange for other, more saleable, shares, even if he doesn't not need them, because it brings him closer to the final position he desires. So while Joe doesn't get cash when he signs the bottom line, he does get the next best thing, Bob's liquid shares, which are far easier to turn into cash than his own. The amount that Bob asks as a fee for superior liquidity is the forfeiture of $2 a year in potential earnings, hardly a large price for Joe to stump up if he is desperate for a getaway from the fishing industry.

After gobbling up Joe's store, Bob continues rolling up the fishing store industry by constantly printing up new shares to buy out folks like Joe who want an exit. Bob and his merry band of shareholders are content to fabricate this desired liquidity as long as they get a portion of each exiting store owners' earnings and the ensuing boost to the share price. The Joe's of the world are happy to give up a bit of earnings to Bob for a bit of his liquidity.

This is exactly what a bank does. Just like Bob buys up illiquid ownership positions in fishing stores, banks buy up illiquid IOUs that have been issued by individuals and businesses. Where Bob issued new shares in exchange, a bank offers a different sort of financial asset; the bank's own highly-liquid IOUs, or deposits. Bankers don't engage in liquidity creation for free. In the same way that Bob requires that Joe give up some earnings in return for the liquidity benefit of Bob's shares, bankers require that the person who initially receives the bank's deposits pays an ongoing fee to enjoy the benefits of their superior liquidity, a fee that is otherwise known as interest. The only difference between a banker and Bob is that one is using debt, or bank deposits, as their liquidity carrot, while the other is using equity.

Banks spend large amounts of capital to ensure the superior liquidity of their deposits. Branch networks, ATMs, card payment infrastructure, and secure internet systems must all be built and maintained. Should a bank's deposits lose their liquidity advantage, the benefit of owning those deposits will diminish to the point that no one will willingly pay a fee to purchase them. Individuals will costlessly convert their illiquid deposits into liquid deposits of competitors (banks typically offer free 1:1 conversion among each others deposit brands). If this continues indefinitely, the bank will eventually go bankrupt.

Bob too faces these same sorts of limitations. His roll-up strategy can only continue as long as his shares are more liquid than those of his universe of targets. Once they are no longer special, folks like Joe won't see it worthwhile to forfeit a bit of their earnings to Bob for his shares. Put differently, Bob can continue rolling-up fishing stores only as long as the multiple that the market is willing to pay for his earnings remain significantly elevated relative to those stores that he wants to buy.

Like banking, rolling-up an industry requires continued investment in the mechanisms that promote share liquidity. Bob must buy ever fancier suits, travel ever further afield to advertise the quality of his shares, and list on more stock markets. One of the threats he must constantly face is that of competing roll-ups who also spend to promote the liquidity of their own shares. If the cost of suits is driven too high by the roll-up competition, it may no longer be profitable for Bob to maintain his shares' liquidity.

Roll-ups will also compete for acquisition opportunities. When folks like Joe who want to exit the fishing business receive multiple bids from roll-ups like Bob interested in buying him out, Joe can play Bob off against his competition so that Bob must sell Joe liquidity for less than he would otherwise prefer, perhaps below his cost of creating that liquidity.

When competition among roll-ups creates too much liquidity then investors will start to cut the liquidity premium that they attach to Bob's shares. Bob's acquisition targets will no longer be willing to forfeit as large a piece of their earnings to Bob as they once did in order to enjoy the liquidity of which he was once the only provider. As a result, acquisitions provide ever small returns, the immediate increase in per share earnings and the good old jump in the share price that Bob once enjoyed is increasingly a thing of this past . At some point, it makes no sense for Bob to continue his roll-up strategy. His business will have lost its banking function and now operates like any other fishing store chain—it grows in line with population growth and the market's desire for fishing products.

If investors had been pricing Bob's shares on the assumption of further growth in its banking function, upon the realization that acquisitions are no longer worthwhile they will all sell in earnest, a large decline in Bob's share price being the result. The roll-up game is officially over, as are Bob's days as a banker.

But let's say that Bob successfully guards the liquidity premium that his shares have always enjoyed against the competition. At some point he'll run up against another limitation; there are only so many fishing stores he can buy. Once he has purchased every shop around him, he runs out of accretive acquisitions and the banking function he once profited from suddenly comes to an end.

If he wants to continue his roll-up strategy, one option is for Bob to expand into another line of business, say gun shops. But here he faces a disadvantage in the fact that he has no natural talent in appraising hunting stores. Where his knowledge of the fishing store industry insured him against buying lemons, the odds of him making mistakes as he rolls-up this new industry increases. This risk isn't unique to Bob. A banker who specializes in construction loans faces this same risk when he or she expands into consumer lending, or auto loans. Just like an accumulation of bad loans may cause a run on a bank, bad gun store purchases may cause a run on Bob's shares. The value of both deposits and shares as media of exchange is jeopardized when the underlying assets are in doubt.

So to wrap this up (roll it up?), there's nothing mysterious or nefarious about roll-ups. They are merely entities that provide banking services to the industries in which they operate, namely swapping illiquid assets for liquid ones. They earn a return for producing liquidity in the form of an accretive earnings bump on each acquisition. Once they reach certain natural limits, a roll-up will cease providing banking services to the industry and return to being a normal company.

The larger point I'm trying to make, however, is that there are monetary phenomena at play in all sorts of situations that don't involve money proper. Monetary economists, those folks who study monetary phenomena, focus laser-like on a narrow range of goods they consider to be money, usually central bank notes and private deposits, thus excluding all other objects from the study of monetary phenomena. This is too bad. When we allow ourselves to think of money not as an either/or proposition but as an adjective that applies more or less to all valuable goods, then you'll see fascinating monetary phenomena all around you, such as the corporate roll-up.

5 comments:

JP, excellent piece, and the "freakonomics" approach to monetary phenomena is really important to develop. I'd take it one step further in that tight monetary policy (where NGDP is slowing) makes cash flow more valuable (and lowers interest rates). This raises the value of any small-cash-flow-generating enterprise, and thus increases roll-up activity.

Companies are more likely to acquire growth into tight-money climates, as the bigger balance sheets are the only liquid game in town: they have the cash flow, and the cheapest cost of capital, and need to acquire more in order to keep cash flows up. Because they are big, they can fund via capital markets cheaply. You have go get big fast, and sell out faster.

Economies with tight monetary policy tend to see consolidation into ever-larger balance sheet entities. Even the largest balance sheet of all -- the government -- becomes the only game in town: the only liquidity provider for a host of needs, as organic opportunities shrink.

The shape of the economic landscape changes, and society changes, depending on the shape of monetary policy. What is intriguing is whether what you are seeing will reverse course if NGDP is stimulated effectively, and interest rates rise: will there be as many roll-ups into a declining present value of established cash flow enterprises?

Good comment. I can see how the demand for roll-up liquidity would increase if those anxious for an exit can't find conventional ways to sell because money is generally tight. In the same way that tight money breeds barter, the creation of private scrip money, and other monetary innovations, rollups may be just one of many innovations to fill the missing liquidity gap. I'm not sure about the empirics of this: do we actually see increased roll-up activity when NGDP is slowing?

There are also "size" roll-ups, where investors launch a shell company (e.g. a capital pool company listed on the TSX Venture), or reverse takeover etc., and try to roll-up a bunch of small private co's in "related" areas (rather broadly, e.g. technology), to get big enough to list on a bigger (more liquid) exchange. These tend to be procyclical (capital dependent), not dependent on government administered rates. It's true, many M&A transactions are driven by financial engineering (in fact, all corporate stucture is essentially financial eng) and are affected by gov rates, but I'm not sure it is about tight or loose money, but portfolio theory based on the risk-free rate.

Well, if we say that roll-ups are the present value monetization of earnings stream value, and high interest rates are associated with easy monetary policy and high NGDP, then the inverse relationship between P/Es and rates may apply: higher P's suggest more demand for company cash flows, of which roll-ups are a symptom.